The Undercover Economist by Tim Harford

13/10/2013

The Undercover Economist follows the mould of recent books such as Freakonomics in trying to bring economic ideas and the economic way of thinking to a mainstream and much wider audience. Tim Harford adeptly applies the economic lense to coffee beans, international development, health insurance, the recent global financial crisis and other areas of interest.

An addition which Mr Harford makes to these ideas is the importance of information which is delivered through the pricing mechanism inherent within markets. When I purchase a coffee for $3 this sends a signal to the merchant that I value coffee at or above the price of $3. He may wish to sell me the coffee for much more than $3 but he knows that I likely have several options about where I may purchase my coffee which forces him to keep his price lower then he would like. However, he knows about the cost of the various input goods that go into the production of this cup of coffee including the young barista’s wages, the beans themselves and the rental of the location..

Location location

It is here that Mr Harford introduces another important economic concept, that is that scarcity helps to create value. He asks the questions why is there only one coffee bar in an airport or train station (or other busy commuter transport thoroughfare)? And why does it cost more than the same coffee does in the local supermarket outside the airport or train station 200 metres away. The answer has everything to do with location. As I mentioned earlier, a key input cost for many businesses is the rental on the site they use to trade which is paid to the landlord. A busy place like an airport is likely to have significant numbers of commuters passing through who are all potential customers, hence the site is attractive to a coffee shop owner and drives up the rental price the landlord wants to charge. So we might know in part why the price is higher in such a place than elsewhere but why is there only one shop in such an area. One might think that many businesses would recognise the value of the site and all pay the landlord to set up shop in the same spot and hence the competition would drive prices back down.

The answer is that a location where you as a coffee shop owner are competing with many different sellers is now a far less attractive proposition than when you were the only seller. The landlord realises he cannot command so high a price for the site if there are multiple tenants (in fact he may not attract any interest from potential tenants). Instead he sells an exclusive right for the site to the highest bidder recognising that this price will exceed the sales in the previous scenario.

The importance of the margin

Mr Harford teaches another key lesson in introducing the importance of marginal cost to influencing people’s decisions when he recounts the story of university societies which sold tickets to parties and provided unlimited alcoholic beverages once the ticket had been paid. The ticket price for alcohol drinkers might be perhaps $10. A non alcoholic ticket was also sold at a much cheaper price but offered “rancid orange juice” whilst you suffered the boorish behaviour of alcohol drinkers. Soon after it became apparent that drunkenness at these parties was an issue so university officials resolved to address it by raising the entry fee for alcohol drinkers.

The change did not affect behaviour and drunkenness remained a problem. The reason for this is that the ticket price is a sunk cost, once the fee has been paid, there are no additional charges to be met and drinkers can consume as much as they wish. There is no charge at the margin so it is irrelevant whether a party goer drinks 1 beer or 10. As Harford notes, a better response would be to charge a rate for each additional drink so drinkers would have real incentives to moderate their intake.

Other ideas and conclusion

Harford also touches on other areas such as the market for healthcare insurance and imperfect information, the dangers of implicit subsidies on large banks and the case for corrective taxes on externalities such as pollution which have a wider negative impact not fully internalised within the transaction by the producer and/or the consumer.

The book is easy to read and follows a nice, logical order. Harford does well at articulately the economic view on various aspects within the economy and wider society, considering the positive and negative implications of different proposed policies. Since the success of Freakonomics, there have been a number of texts attempting to popularise the ideas of economics and the economic way of thinking (a big part of which is thinking at the margin where behaviour is affected), Harford joins this quest and in my opinion with The Undercover Economist succeeds. For me the book brought together some of the key ideas about information and scarcity which I had been introduced to in introductory micro economics and gave it some more practical real world applications. An enjoyable read.